Encyclopedia of Investment Terminology

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Initial Public Offerings (IPO)

IPO stands for initial public offering and occurs when a company first sells its shares to the public.

The underwriters and the company that issues the shares control the IPO process. They have wide latitude in allocating IPO shares. The SEC does not regulate the business decision of how IPO shares are allocated.

While smaller or individual investors are finding it easier to buy IPO shares through online brokerage firms, they may still find it difficult to buy IPO shares for a number of reasons:

The Underwriting Process

The IPOs of all but the smallest of companies are usually offered to the public through an "underwriting syndicate," a group of underwriters who agree to purchase the shares from the issuer and then sell the shares to investors. Only a limited number of broker-dealers are invited into the syndicate as underwriters and some of them may not have individual investors as clients. Moreover, syndicate members themselves do not receive equal allocations of securities for sale to their clients.

The underwriters in consultation with the company decide on the basic terms and structure of the offering well before trading starts, including the percentage of shares going to institutions and to individual investors. Most underwriters target institutional or wealthy investors in IPO distributions. Underwriters believe that institutional and wealthy investors are better able to buy large blocks of IPO shares, assume the financial risk, and hold the investment for the long term.

Hot IPOs

When an IPO is "hot," appealing to many investors, the demand for the securities far exceeds the supply of shares. The excess demand can only be satisfied once trading in the IPO shares begins. It is unclear how "hot" the offering will be until close to the time when the shares start trading. Since "hot" IPOs are in high demand, underwriters usually offer those shares to their most valued clients.

Underwriting firms that have a high percentage of individual investors as clients are more likely to allocate portions of IPO shares to individuals. Several online brokers offer IPOs, but these firms often have only a small allotment of shares to sell to the public. As a result, individual investors' ability to buy these shares may be limited no matter which firm they do business with.

Eligibility Requirements

By their nature, investing in an IPO is a risky and speculative investment. Brokerage firms must consider if the IPO is appropriate for individual investors in light of their income and net worth, investment objectives, other securities holdings, risk tolerance, and other factors. A firm may not sell IPO shares to an individual investor unless it has determined the investment is suitable for that particular investor.

Other Restrictions

Even if the firm decides that an IPO is an appropriate investment for an individual investor, the brokerage firm may sell the IPO only to selected clients. For example, before you can purchase an IPO, some firms require that you have a minimum cash balance in your account, are an active trader with the firm, or subscribe to one of their more expensive or "premium" services. In addition, some firms impose restrictions on investors who "flip" or sell their IPO shares soon after the first day of trading to make a quick profit. If you flip your IPO shares, your firm may refuse to sell you other IPOs altogether or prevent you from buying an IPO for several months. You can often find these restrictions on the firm's website.

You may have found that there can be a large difference between the price of an initial public offering (IPO) and the price when the IPO shares start trading in the secondary market.

The pricing disparities occur most often when an IPO is "hot" or appeals to many investors. When an IPO is "hot," the demand for the securities far exceeds the supply of shares. The excess demand can only be satisfied once trading in the IPO shares begins. This imbalance between supply and demand generally causes the price of each share to rise dramatically in the first hours or days of trading. Many times the price falls after this initial flurry of trading subsides.

No brokerage firm can guarantee you will be able to purchase shares in an Initial Public Offering (IPO).

While it can be difficult for individual investors to buy IPO shares, more and more firms, including several online brokers, offer IPOs. Because these firms often have a small allotment of shares to sell to the public, your ability to buy these shares especially "hot" IPOs may be limited no matter which firm you do business with.

By their nature, investing in an IPO is a risky and speculative investment. Brokerage firms must consider if the IPO is appropriate for you in light of your income and net worth, investment objectives, other securities holdings, risk tolerance, and other factors. A firm may not sell to you IPO shares unless it has determined the investment is suitable for you.

Your brokerage firm may also sell the IPO only to selected clients. For example, before you can purchase an IPO, some firms require that you have a minimum cash balance in your account, are an active trader with the firm, or subscribe to one of their more expensive or "premium" services. In addition, some firms impose restrictions on investors who "flip" or sell their IPO shares soon after the first day of trading to make a quick profit. If you flip your IPO shares, your firm may refuse to sell you other IPOs altogether or prevent you from buying an IPO for several months. You can often find these cash requirements and eligibility policies on the firm's website.

Much of the above information is courtesy of the SEC.


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